As we’ve discussed on quite a few occasions, voracious appetite for HY issuance (which hit $90 billion in Q1) coupled with artificially low borrowing costs has allowed otherwise insolvent oil producers to keep drilling in the face of the global commodities downturn contributing not only to depressed oil prices, but also to an increase in the amount of risk that’s embedded in US HY credit markets. Consider the following graphics which tell the story quite nicely:
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Despite the obvious risks that go along with throwing money at highly leveraged shale companies ahead of Q1 results which will invariably include huge writedowns [15] as E&Ps are forced to calculate PV-10 based on prices that bear a stronger resemblance to market prices than they did at the end of last quarter, “investors” have continued to chase double-digit yields seemingly undeterred by the fact that even in a world where credit markets have been stripped by central banks of their ability to price risk, an 11% coupon still spells trouble. For their part, UBS sees a “correction” just around the corner. Here’s more:
We have maintained an underweight on the US high yield (HY) energy sector (ex-gas pipelines) since the fall of last year. In recent months, that view has been the wrong one. Why are we sticking with our view? First, the rally in energy sector bonds has coincided with not only the stabilization and modest recovery in oil prices but also a constructive backdrop supported by dovish central bank actions and solid HY fund inflows. With HY market valuations entering expensive territory versus our model forecast, we are growing concerned that HY market valuations will correct and energy will underperform with higher beta credit…
Second, valuations in the HY energy sector look rich under most reasonable default rate scenarios. Put differently, an oil price recovery towards the 60s and 70s this year and next is already reflected in current bond prices. The energy sector currently trades at a yield of 7.8% and spread of 661bp; in comparison, the overall market ex-energy trades at a yield of 5.5% and spread of 447bp (Figure 1). For the weaker sub-sectors, secondary E&P and oil service bonds yield 8.7% translating to spreads of 765bp and 733bp, respectively. In short, energy and the lower quality segments trade at spread discounts of 214bp and c300bp versus the market. And the bulk of the excess spread can be found in the oil service and triple C sub-segments (Figures 2 & 3). We continue to believe default rates could reach 10 – 15% for HY energy as a whole by mid-2016, which would translate into 15-20% for the weaker sectors. Our prior analysis suggests energy sector spreads could be 300 – 600bp wider than the current index if oil prices remain low for longer. Investors are simply not being rewarded for the incremental risk.
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And as for the defaults well, they’re on their way UBS thinks, as evidenced by recent events such as American Eagle Energy’s “Movie Gallery [17]” moment:
Where are the defaults? They're coming: we've seen Quicksilver Resources and Dune Energy, are likely to see American Eagle Energy, RAAM Global Energy, Venoco and thereafter perhaps Connacher Oil & Gas, Samson and Sabine Oil & Gas. Most E&P firms had hedges in place for 2015; defaults typically lag by about 12 months and the clock started ticking late last year.
We’ve talked a lot lately about HY in general and about the HY energy space more specifically. Recapping, periods of QE in the US saw US HY supply surge 50% above normal levels as issuers sought to take advantage of lower borrowing costs and investors clamored for the relatively higher yields they could get by taking on more credit risk. More recently, struggling oil producers have tapped the market in an effort to stave off insolvency as crude prices plummet, leading directly to a situation where outstanding HY energy bonds account for a disproportionate share of all outstanding debt in the space. With rates set to rise later this year, with crude prices likely to stay depressed for the foreseeable future, and with suppressed liquidity in the secondary market for corporate credit poised to bring heightened volatility, the stage may be set for a high yield meltdown.
